ISO files are basically images of the CDs. You use a program like
Daemon Tools to create a virtual CD drive and then point the drive at the ISO file. From then on your computer will act as if the real CD had been placed in a real drive.
What's causing your problem is that at the moment for some reason you don't have CD2 mounted any more. Dameon Tools will let you have 4 virtual CD drives so you can easily mount CDs 2 and 3 (The game only ever asks for CD1 during installation) and that should end your problem. No doubt what software you're using isn't mounting CD2 properly (or you aren't mounting it properly

) and therefore the game can't find the CD it's looking for.
Regardless of all that Stratcomm gives some good advice. SCP is well worth checking out and is a solution for the problem of it constantly asking for CD2. Simply choosing the burn image option in whatever CD burning program you have and burning CD2 to a real CD is another.